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Best Practices: Know Your Debtor

by Starfield & Smith

The automatic stay in bankruptcy is a powerful tool for a debtor and a major component of providing the Debtor with the “fresh start” intended by the Bankruptcy Code. While most of the case law on the automatic stay centers on how the stay operates, it is equally important to understand who the stay protects.

The automatic stay is very narrowly construed regarding who it protects. The stay is only applicable to the debtor. The stay does not extend to the debtor’s principals, managers or affiliates. In other words, if the borrower files, the lender can still exercise its rights with respect to all individual and corporate guarantors, unless those entities have filed their own bankruptcy petitions.

Only a husband and wife can be joint debtors. For corporate entities, each company must file its own petition in order to be protected by the automatic stay. The existence of jointly administered cases creates a fair amount of confusion in this regard. If several affiliated companies file bankruptcy petitions concurrently, they commonly file a motion on the first day of each case to “jointly administer” the cases of the affiliates under a single caption. Courts typically grant this relief immediately.

To the uninitiated, it looks like a single bankruptcy case covers several entities. In reality, each entity filed its own bankruptcy petition and each entity’s creditor body and asset pool remain distinct even if the case is “jointly administered” with affiliates’ cases.

Frequently with SBA loans, we see the principal of a single-member LLC file an individual bankruptcy to discharge his/her obligation on a personal guaranty. Unless the LLC filed its own bankruptcy petition, the automatic stay does not apply to it. A lender should continue with collection efforts against the LLC as if the principal’s bankruptcy never happened.

More importantly, the lender should monitor the principal’s case. Lenders should make sure that the principal is not liquidating the LLC’s assets to satisfy the principal’s personal creditors. The LLC’s assets should only be applied to the LLC’s debts. In closely held companies, the principal may ignore that distinction. The LLC’s lender needs to be vigilant.

In some instances, the court can order extension of the automatic stay to protect non-debtor entities. This typically happens when a company files a Chapter 11 case and its senior management is critical to the debtor’s successful reorganization. The court will enjoin collection efforts against the individuals so that they can focus attention on the business’ reorganization.

The individuals, however, must petition the court to have the stay extended to them. Lenders should oppose this type of relief unless the individuals offer something in return, such as a personal contribution to the payout to creditors or the pledge of additional collateral.

The automatic stay is broad in application, but narrowly focused on the debtor only. When a lender is confronted with an automatic stay issue, it should always be mindful of who the debtor is and be guided accordingly.

For more information regarding bankruptcy in the context of SBA lending, please contact Greg at (215) 542-7070 or email him at GKupniewski@StarfieldSmith.com.